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Why Government Stimulus Doesn’t Work

The incoming Presidential Administration and the new Congress appear set to spend hundreds of billions of dollars on new government programs, physical infrastructure and “relief” for those affected by the recent economic downturn. They plan to do this through deficit spending, requiring them to sell bonds and, perhaps eventually, raise taxes. The underlying concept is the Keyensian-based idea that if government spends enough money it can smooth out economic recessions, limiting their impact.

It is true that government can spend money on infrastructure and new government jobs and even directly inject money into businesses and this will create some temporary jobs. The hope of the Obama Administration and its supporters in Congress is that these temporary jobs will provide the foundation for more wide-spread, longer-term growth. Indeed, it is likely that the increased government spending will smooth out some of the effects of this latest recession. Unfortunately, this is probably the least effective method for generating growth.

The reasons why government stimulus doesn’t work is that government, by and large, does not invest. Even in those situations where it does invest, it often does not invest intelligently. Growth is not achieved merely by spending. Spending is merely a consumptive process based upon the immediate needs of the individual, business or government. In order to create economic growth, we must invest. Investing is a long-term process based upon the known and projected future needs of individuals, business and government. By merely spending, government consumes resources but does not create any new resources (the lone exception being when it builds infrastructure such as roads-something that private businesses are proving they can still do better).

The hope of the Keynesian inspired government official is that this spending will put money in the hands of those who can invest, so that they will then use that money to create more jobs. This effect does occur, and arguing that it does not, as many libertarians and conservatives do, is a fallacy. The significant problem is not that it does not work well. The significant problem is that it is terribly inefficient; so inefficient that most frequently by the time most of the money gets someplace where it is invested and working to grow the economy, the economy has already recovered on its own.

Government stimulus almost always occurs after the economy has started to falter. This means that there is existing overcapacity in the various industrial sectors (for the purposes of this discussion, industry includes services). That overcapacity is why the economy began to falter in the first place: Too much production and not enough demand. Businesses cut back and consolidate, which leads eventually to job cuts. This is the natural state of an economy: Growth, maturity, contraction, stabilization and finally growth again. Government stimulus in the form of rebates artificially creates demand that extends the period of overcapacity and causes higher peaks (with associated deeper troughs). Meanwhile, direct government investment encourages consolidation because the overcapacity already exists, money is available to pay for the costs of consolidation, and this in turn worsens the contraction and delays stabilization.

Government stimulus artificially creates new demand for existing products and services, but does not encourage demand in new businesses or products. The reason is simple: Governments don’t invest in start-ups. When governments invest, it is in existing, established businesses. These are, of course, the ones most likely to succeed. As any entrepreneur or venture capitalist will tell you, most new businesses fail. To government, investing in new business is a waste, since the majority of those businesses will cease to exist in a few years.

We’re talking about jobs, after all, not wealth. Government wants to make sure that there are millions of taxpayers who will help fund the government, and the easiest and quickest way to do that is to inject money into big business.

Never mind that the very reason these businesses are large is that they are mature. They have reached the point where growth comes slowly, or where contraction is inevitable, and the focus is on consolidation of gains and moderate, steady and efficient growth. So a large (Fortune 1000) company could receive a billion dollars in “stimulus” from the government, and that investment may lead to a five thousand jobs and moderate, paced developments.

Meanwhile, five hundred small companies could receive just a million dollars each, and each would add five, ten or twenty jobs and invest in new equipment that could double or triple their capabilities or efficiency. If they average ten jobs each, their stimulus is already twice as effective as that of the larger company, as they have added as many jobs for half the price. If they average 20 jobs each, they are four times as effective.

The best way to get such an investment to these companies is to not have a government bureaucrat decide what businesses are best to invest in. Such a bureaucrat, as discussed above, would see the risk in new or small business and immediately choose the established large operator. Their choice can be influenced by politics, both personal and public, or mandated by Congressional decree (see discussions on earmarks if there is any doubt of this). Washington then picks political winners and losers in the economy, who provide services that are politically acceptable, rather than items of value to individual consumers.

Japan has tried this approach. They have had “stimulus” after “stimulus.” It hasn’t worked, and their economy remains stagnant.

The alternative approach is to encourage private investment among those who have the resources to do so. Investing either in existing businesses or in new start-up companies based upon the investor’s belief in the potential of the business venture. Certainly, several of these companies will fail, but at least the ones that succeed will be providing goods and services that we as consumers value.

Ireland tried this approach: They Lowered taxes to encourage more investment. The “Irish Miracle” has been largely ignored by the media, but Ireland has gone from a nation of stagnant growth and mass-exodus for generations to one of the most desireable places in which to emigrate and establish businesses.

The Heritage Foundation recently published a treatise on how the stimulus package of 2001 did little to stimulate the economy, but the 2003 tax cuts caused an almost immediate stimulation to investment, growth and new jobs. They are more studied and eloquent than me, but refute only “consumption” stimulus, such as rebate checks. They do not refute the idea of “investment” stimulus, which the TARP funds and other proposed “stimulus” ideas encourage.

Supply-side economics have been lampooned as “trickle-down” and favoring the elite. This is unfortunate, because it obfuscates the fact that the very methods that create wealth for the “elites” is also the greatest method of generating new wealth that can be shared by anyone with the audacity, tenacity and guts to earn it by creating a new business or growing an existing company. Will we learn too late the fallacy of Keynes and to lunacy of “consumptive” economics?